Long-run value at heart of Buffett success

Warren Buffett
is no doubt the most celebrated investor alive, if not the best that has ever lived. According to Forbes magazine, he’s at present the world’s third-richest person, worth $US47 billion. At 79 years of age, he talks more of retirement each year, but – like Rupert Murdoch – shows few signs of slowing down.

His Berkshire Hathaway fund has generated compound annual returns of 20.2 per cent since 1965, compared with annual total market returns for the S&P 500 fund of 9.4 per cent. It means $10,000 invested at the start of 1965 (worth about $40,000 in today’s dollars) would now be worth $630,000 if invested in the S&P 500, but $49 million if invested with Buffett.

What’s more, Buffett’s returns are after income and capital gains taxes have been duly paid each year – the S&P 500 is in pretax terms.

Naturally, many books have been written about Buffett’s investment methods, and most are directed at showing average retail investors how they can copy the methods of the great man. But having read several of these books, it struck me that Buffett is more than just a passive investor with an uncanny eye for value. He does things mere mortals cannot.

Of course, many of these books delve deeply into Buffett’s “value" approach to investing – namely how to pick good cheap stocks. It’s at least this aspect of his approach retail investors can emulate when buying on the market.

But there are many professional value investors out there, equipped with forensic abilities to dissect a balance sheet, yet few come anywhere near Buffett’s consistent performance.

Picking cheap stocks – with undervalued assets or earning power – is not rocket science. Even with fairly cheap scanning software, almost any investor can identify stocks with very low price-earnings or price to book value ratios, strong returns on equity, and/or little debt.

But more often than not, Buffett does much more. So it’s a bit unfair to expect average investors to replicate his performance. We can’t, so we should not be upset about it.

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For starters, Buffett usually takes control of companies that he buys – especially his very large bets. He is not a passive investor, which places him in a much stronger position than the average professional fund manager or retail investor. Effectively, he eliminates management risk by making them answerable to him. And in that sense, his fund is closer to a private equity firm than a fund manager.

This helps greatly given there is what called an “agency problem" between management and shareholders – especially as companies get larger. The management could focus on short-term means to boost profits and their bonuses but which are ultimately costly – like buying dodgy businesses. Or it could waste money on lavish head offices and bloated salaries.

This first thing Buffett does when he takes control of the company is capital management – ensuring companies retain only as much money as they need to generate high returns on equity. Excess profit is taken off as dividends and invested elsewhere in the Buffett empire. Similarly, if the company can greatly boost earnings through more investment he might cut the dividend and/or direct some of Berkshire’s cash its way.

Another factor in Buffett’s favour is his ability to buy unlisted companies – often for a song. Again this is not generally possible for fund managers with mandates to buy only listed companies, much less retail investors. Buffett even invites people who are running business that they think he might like to buy to give him a call. He will scrutinise the books and then make an offer – though it could be at a substantial discount to what the stock might be worth were these companies to go to the trouble of listing on the sharemarket.

He’s been known to buy unlisted companies at a P/E ratio of 5 to 10 times – a fraction of what similar listed companies might sell for.

Another neat trick is that, unlike most fund managers and retail investors, Buffett judges his performance by something he can better control – the book value of his investments, rather than their often more variable market prices. Markets can rise and fall, but provided he has picked companies that churn out fairly high and steady returns on equity, book value should rise nicely each year.

As a result, Buffett does not need to rely on share prices rising to generate his performance – he only needs to ensure his companies are making good money. So if he can spot a company that consistently generates a 20 per cent return on equity, he knows its purchase will add to his book value performance, even if there’s no catalyst for its share price to rise in the short to medium term. And provided it’s making such healthy returns, why sell, ever?

This is also why Buffett can snap up bargains during market downturns, even if he’s early and market prices fall further. His self-defined measurement system allows him to catch falling knives – such as Goldman Sachs during the global financial crisis, and some of America’s premier consumer companies during previous market downturns. In this sense, Buffett can act like a classic vulture fund.

So in many regards, Buffett does things average investors can’t hope to match. But one lesson for us is to focus more on the underlying earnings power of companies we invest in rather than the whims of market pricing – especially if we have bought established blue chip stocks with fairly assured earnings power over the long-term.

As Buffett has demonstrated, providing you focus on long-run value, market timing can work: buy when others are fearful, not greedy.